In the world of lending and borrowing, uncertainties are always there. Moreover, due to the ever-changing situation in the economy, there are constant changes in the financial markets.
These changes affect the interests, income, and investments of lenders and borrowers.
So, to keep up with such changes, some tools are introduced that can help both lenders and borrowers be safe from exploitation or unforeseen loss.
One of such tools is Yield Maintenance. It helps the lenders be assured of the earnings they are subjected to receive regardless of the borrower’s choices.
Read this article to understand what is yield maintenance and how does yield maintenance work?
Yield Maintenance Definition
What is Yield Maintenance?
Yield maintenance is prepayment fees or a penalty that a borrower pays the lender for repaying the loan before the maturity period. This is a sort of compensation or reimbursement that a lender receives for the leftover period of maturity of the loan that he will not receive the interest for.
This yield maintenance prepayment penalty is calculated by finding the difference between the decided interest rate of the loan and the current market interest rate and paying for the period left before maturity.
This helps the lender not incur any loss or difference in the income through interests if the borrower plans to pay early. However, due to this penalty payment, the borrowers sometimes feel uninterested in refinancing.
Yield maintenance process
The yield maintenance process starts when borrowers obtain funds through many sources like mortgages, bonds, loans, etc. For the amount borrowed, also known as the principal, the borrower pays a certain amount or fees for using the lender’s money. This fee is known as interest. Interest is usually delivered in equal installments (primarily annual), at an agreed rate, for the agreed period (also known as the maturity periods). Thus, the interest, till the maturity period, is the earning for the lender.
Yield maintenance can be better understood with the help of an example.
How does Yield Maintenance Work?
For example, a borrower takes a loan of $500,000 (principal) at an agreed rate of 5% for ten years. This means that the lender will receive the interest of $500,0005%=$25,000 per month for ten years. Thus, his total earnings till the maturity period, when the loan is to be repaid, will be $250,000.
Due to some reasons, the borrower plans to repay the loan amount before the loan’s maturity. He pays the loan within five years. This loan repayment before maturity is a prepayment risk for the lender, as he losses the estimated income through interest for the agreed-upon period.
This is where the yield maintenance comes to the rescue of the lender. As it is a maintenance charge, it lets the lender earn the exact yield they were supposed to make without prepayment. So, it helps the lender to be free from such risks and losses. However, due to these fee or penalty charges, borrowers also avoid the prepayment as it increases their payments, supplementing the lender’s prepayment risk.
Though yield maintenance situations are rare in short-term loans, they are more commonly found in the commercial mortgage industry. For example, there is a builder who wants to buy a building. To buy that, he takes out a mortgage loan of 25-years. But, within ten years after taking the loan, due to economic conditions, the market rate of interest fell, and he got the opportunity to refinance his loan at a lesser rate of interest. So, he borrows the money from a different bank or lender, who offers a lesser interest rate, and repays the loan amount to the current lender or bank. To reinvest this refunded amount and get the equivalent income or interest charges, that should have been the case if the loan was not repaid before maturity. They must charge the yield maintenance from the borrower and add this maintenance charge to the reinvested amount.
Yield Maintenance Calculation Example
Following is the formula for calculating yield maintenance charges on a loan or mortgage:
Yield Maintenance = (Interest Rate – Treasury Yield) x Present Value of Remaining Payments on the Mortgage
The formula for calculating the PV (present value of remaining payments) is:
(1 – (1+r)-n/12)/r
Here, r is the treasury yield, and n is the number of months.
Now let’s take the above example of the loan where the borrower took $500,000 for ten years at a 5% interest rate and repaid it within five years. Now he has a $250,000 remaining loan amount to be paid with a term remaining for the maturity as five months, equivalent to 60 months. The yield on this 5-treasury note at the time of repayment is 4%. Therefore, we will calculate the yield maintenance charges in the following way:
First, we will calculate the Present Value of the remaining loan using the above formula:
PV= [(1 – (1.04)-60/12)/0.04] x $250,000
Now, with this PV we can calculate the Yield Maintenance
Yield Maintenance= $1,112,500 x (0.05 – 0.04)
Therefore, the yield maintenance charges or premium that the borrower would have to pay while prepaying the loan will be $11,125, an additional cost.
Sometimes, instead of going down, the treasury yield increases. This means that the market rate of interest is now more than the agreed-upon rate of interest for the current loan. In this case, the lender will not lose any yield and profit if the loan is prepaid. This is because they can re-lend or re-invest the same amount at a higher interest rate, increasing the lender’s income. But, like a prepayment penalty, the borrower will still have to pay the yield maintenance fees to the lender.
The yield maintenance charges are a haven for the lenders. It helps them prevent themselves from any losses, assuring them that they will receive their income anyways. Even if the borrower decides to prepay the loan, no matter what the market treasury yield is.